Is the bond market experiencing a bubble?
Ever since 2008 the Federal Reserve cut short-term interest rates to near zero and began buying bonds in 2008, commentators have worried that bond prices were unsustainably high. They feared that investors could suddenly flee the bond market, causing prices to collapse and yields—which move inversely to price—to jump higher.
Recently, former Federal Reserve Chairman Alan Greenspan reflected these concerns when he warned in a TV interview that bond yields were unsustainably low and that the market was in a bubble.
So what’s Schwab’s view?
Exuberance is lacking
“We think bond yields are likely to rise from current levels as the economy continues to improve and the Federal Reserve tightens policy, but we don’t see a bubble in the market,” says Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research.
Although there is no standard definition of what constitutes a market bubble, Investopedia’s definition—“a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior”—seems reasonable, Kathy says.
“By that measure, the bond market doesn’t appear to be in a bubble. It’s hard to find investors who are exuberant when yields are so low,” Kathy says. “Moreover, since bonds have a stated yield to maturity, it’s pretty clear what the return on investment will be for a given security, barring default. These days, those returns are hardly cause for exuberance.”
Schwab’s capital markets expectations for the next 10 years suggest U.S. investment-grade bond returns will average just 3.1% per year.
Slow economic growth, low inflation, easy central bank policies and strong investor demand for predictable income-generating assets also should continue to support the bond market, Kathy says. Longer-term, she still expects yields to remain below the levels that prevailed before the 2008 financial crisis.
Kathy says it’s also worth noting that the last time bond yields experienced a big short-term jump, it wasn’t a disaster for most investors. In 2013, when yields rose by 100 basis points (or one percentage point) across the yield curve in a short period of time, the total return of the Bloomberg Barclay’s U.S. Aggregate Bond Index was negative 2%—hardly a “Bondageddon” scenario.
However, the risk level isn’t zero
Nevertheless, investors shouldn’t be complacent about the potential for yields to move up moderately from current levels, because some of the factors that have driven rates lower are beginning to shift, Kathy says.
“Global economic growth is picking up and we expect further improvement in 2018,” Kathy says. “According to the International Monetary Fund, no major developed country or region is in recession. That may not sound like a big accomplishment, but it is the first time that has happened since 2010, and may signal that the global economy is finally recovering from the financial crisis and recession.”
With economic growth picking up, the risk of deflation has receded in many countries, allowing central banks to pull back from the easy monetary policies of the past decade. For example, the European Central Bank may soon begin slowing down its bond-buying program. The U.S. Federal Reserve has already begun the tightening process, raising the federal funds rate four times in the past two years.
What investors can do now
Fixed income investments are an important part of a balanced portfolio, because they typically provide income and reduce volatility by providing diversification from stocks.
Because longer-term bond yields tend to be more sensitive to interest-rate changes than shorter-term bonds, Kathy suggests keeping the average duration of your fixed income portfolio to less than seven years (and even less than that if your investing time horizon is short). Investors can also use bond ladders to spread out maturities over time, which can be useful in reducing potential volatility. Kathy also favors a cautious approach toward higher-risk fixed income investments, such as high-yield bonds.
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.